Schrager also seems to confuse ex-ante and ex-post in her attempt at an article and to have a definition of “equity premium” that changes while she’s writing. No wonder her conclusion is so weak.

Of course this describes the major index relationship and individual companies will vary depending on their characteristics. Large companies with great balance sheets will have a lower premium as will high growth companies until their growth rates falter.

I get such a big chuckle out of the “Fed Model” and the idiots that promote it. It is best used to measure over-valuation rather than under valuation. Stick to the 10 year B and B- corportes, making suitable adjustments for individual companies, and over the long run you will gain an understanding of valuations.

Equities are inherently riskier than Treasuries. Equity prices must ultimately reflect and compensate investors for that risk or no one would hold them in their portfolio.

The reason you hold them in your portfolio is the earnings. Thus, the earnings should be higher than that of comparable investments. Using Shiller’s data set you can see from 1887 to 1960 the earnings yield averaged 4.53% spread over long term interest rates. Since then it has averaged -0.28%. Why did this happen; when did it become OK to accept a riskier asset class but with less of a stream of income? When it became a ponzi-esque game of the greater fool.

In hindsight, it seems easy to say that in 2006-2008 these gains were finally sucked dry and the equity premium was at an end. Now, however, I believe this second “great recession” has set the stage for a new equity premium. The longer the market stagnates and the most fearful the public becomes, the more gains are bottled up for future investors who are willing to jump in.

I am personally tossing small chunks of cash into stink bid day-orders on blue chip stocks with high yields. This way I control my exposure to short term movements (and recent volatility means I can get discounts of 3-5%) and am paid 4-7% while I wait. These dividends continue to build my cash position.

I also hold a significant amount of fixed-income which I may back off in months or years.

http://faculty.london.edu/edimson/assets  /documents/Jacf1.pdf

The world averaged Geometric Mean equity premium of 4.6% and Arithmetic Mean equity premium of 5.9%

If it is believed there will be no equity premium then the value of equities should fall, increasing the earnings yield and increasing the equity premium. Though it is not guaranteed for any given year or decade it should over time persist. This has persisted for centuries.

Interesting point, growth is not necessary for high equity returns; in fact, I prefer low or no growth. Please read Jeremy Siegel’s Stocks for the Long Run.

Current long-dated TIPS will deliver real returns a bit under 2%. As a result, if you believe equities are vaguely rationally priced, you should mark their expected real returns at greater than 2%. DeLong says 4%? That may be overoptimistic, but it’s in the discussion. Get 1% population growth, 0.5% immigration, excellent 2.5% productivity growth and no significant diminution in profit share, and you’re getting close. I’d be more comfortable with lower productivity growth myself, but I doubt we register a long-run 0%.

One aside: you’re confusing premiums over cash and over bonds. I like to use ‘real return’ instead of the former (since cash returns roughly equal inflation), reserving the phrase ‘equity premium’ for the expected long-term return premium over long treasuries.

The U.S. Equity Return Premium:
Past, Present and Future
J. Bradford DeLong
Professor of Economics, U.C. Berkeley
Research Associate, NBER
brad.delong@gmail.com
Konstantin Magin
Visiting Assistant Professor, U.C. Berkeley
magin@berkeley.edu1

ABSTRACT
For more than a century, diversified long-horizon investments in
America’s stock market have consistently received much higher returns
than investors in bonds: a return gap averaging six percent per year.
This is what Rajnish Mehra and Edward Prescott (1985) labeled the
“equity premium puzzle”: the premium return on equities does not
seem to be matched by any obvious factor that makes the marginal
utility of wealth in states of the world when equities are cheap
sufficiently higher than in states of the world when equities are
valuable. The existence of this equity return premium has been known
for generations. More than eighty years ago financial analyst Edgar L.
Smith (1924) publicized the fact that long-horizon investors in
diversified equities got a very good deal relative to investors in debt:
consistently higher long-run average returns with no more risk. We
conclude that the equity premium puzzle has not been solved: it
remains a puzzle. And we conclude that we anticipate the equity return
premium to continue, albeit at a smaller level than in the past—perhaps
four percent per year.

Sub-prime loans are inherently riskier than prime loans, however some sub-prime MBS’s were not yielding that much more than prime MBS’s (AAA rated tranches at least). You might even have a sub-prime loan with a teaser rate charging less of a premium than a really solid prime loan.

Option-ARMs further that point. An option-arm 100% financing no-doc loan is inherently riskier than a fixed rate prime loan fully-doc’d. Which yielded a better rate for the initial period? The extra risk was negatively compensated!